Part 1: Overview: Monetary Policy and the Economic OutlookMonetary Policy Report submitted to the Congress on July 13, 2011, pursuant to section 2B of the Federal Reserve Act
Economic activity continued to recover over the first half of 2011, but the pace of the expansion has been modest. The subdued rate of expansion reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer spending as well as supply chain disruptions associated with the tragic earthquake in Japan. Nonetheless, even after setting aside temporary influences, the growth of economic activity appears to have slowed over the first half of this year. Conditions in the labor market remain weak. Although the average pace of job creation picked up during the early months of the year, employment growth softened in May and June and the unemployment rate edged up. Meanwhile, consumer price inflation increased noticeably in the first part of the year, reflecting in part higher prices for some commodities and imported goods as well as shortages of several popular models of automobiles. The recent rise in inflation is expected to subside as the effects of past increases in the prices of energy and other commodities dissipate in an environment of stable longer-term inflation expectations, and as supply chain disruptions in the automobile industry are remediated.
On net, financial market conditions became somewhat more supportive of economic growth in the first half of 2011, partly reflecting the continued monetary policy accommodation provided by the Federal Reserve. Yields on Treasury securities and corporate debt as well as rates on fixed-rate residential mortgages fell to very low levels, on balance, over the first half of the year, and equity prices rose. Borrowing conditions for households and businesses eased somewhat further, although credit conditions remained tight for some borrowers.
After rising at an annual rate of 2-3/4 percent in the second half of 2010, real gross domestic product (GDP) increased at about a 2 percent rate in the first quarter of 2011. Available information suggests that the pace of economic growth remained soft in the second quarter. Real consumer spending, which had brightened near the end of 2010, rose at a noticeably slower rate over the first five months of 2011, as household purchasing power was constrained by the weak pace of nominal income growth and by rising fuel and food prices, and as consumers remained downbeat. Meanwhile, the housing market continued to be weighed down by the large inventory of vacant houses for sale, the substantial volume of distressed sales, and by homebuyers' concerns about the strength of the recovery and fears of future declines in house prices. In the government sector, state and local government budgets continued to be very tight, as a reduction in federal assistance to those governments was only partially offset by an increase in tax collections; in addition, federal spending appears to have contracted. In contrast, exports--which have been a bright spot in the recovery--moved up briskly, and businesses continued to increase their outlays for equipment and software.
In the labor market, private payroll employment gains picked up in the first four months of the year, averaging about 200,000 jobs per month, an improvement from the average of 125,000 jobs per month recorded in the second half of 2010. However, private employment gains slowed sharply in May and June, averaging only 65,000 per month, with the step-down widespread across industries. Furthermore, the unemployment rate, which leveled off at around 9 percent in the early months of the year, has edged up since then, reaching 9.2 percent in June. The share of the unemployed who have been jobless for six months or longer remained close to 45 percent, a post–World War II high.
Consumer price inflation picked up noticeably in the first part of 2011. Prices for personal consumption expenditures rose at an annual rate of about 4 percent over the first five months of the year, compared with an annual rate of increase of a little less than 2 percent during the second half of 2010. A significant portion of the rise in inflation was associated with energy and food prices, reflecting the pass-through to retail prices of surges in the costs of crude oil and a wide range of agricultural commodities. Recently, however, these commodity prices have apparently stabilized, a development that should ease pressure on consumer energy and food prices in coming months. Another important source of upward pressure on inflation during the first half of the year was a sharp acceleration in the prices of other imported items. This factor contributed to a pickup in consumer inflation for items other than food and energy; over the first five months of this year, such inflation ran at an annual rate of more than 2 percent, up from an unusually low 1/2 percent annual rate of increase over the second half of 2010. Despite the increase in inflation, longer-term inflation expectations remained stable.
In U.S. financial markets, strong corporate profits and investors' perceptions that the economic recovery was firming supported a rise in equity prices and a narrowing of credit spreads in the early part of the year. By May, however, indications that the economic recovery in the United States was proceeding at a slower pace than previously anticipated--as well as a perceived moderation in global economic growth and heightened concerns about the persisting fiscal problems in Europe--weighed on market sentiment, prompting a pullback from riskier financial assets. On net over the first half of the year, yields on longer-term Treasury securities declined. Yields on corporate debt and other fixed-income products as well as rates on fixed-rate residential mortgages fell from already low levels, and credit spreads were little changed. Broad equity price indexes rose significantly, on balance, over the first half of the year; however, stock prices of banks declined.
By early July, investors had marked down their expectations for the path of the federal funds rate relative to the trajectory anticipated at the start of the year in response to economic and financial developments and the reiteration by the Federal Open Market Committee (FOMC) that it expected to maintain exceptionally low levels of the federal funds rate for an extended period. These same factors, as well as safe-haven demands stemming from investor concerns about global economic growth and about developments in Europe, contributed to the decline in nominal Treasury yields. Thus far, uncertainties surrounding the outcome of discussions to raise the U.S. government's statutory debt limit do not appear to have left an appreciable imprint on Treasury prices, but investors have noted statements by major ratings agencies regarding the actions the agencies may take if the fiscal situation is not adequately addressed. Measures of inflation compensation derived from yields on nominal and inflation-indexed Treasury securities fluctuated over the first half of the year in response to changes in commodity prices and the outlook for economic growth. On balance, medium-term inflation compensation edged higher over the first half of the year, but compensation further out was little changed.
Large nonfinancial corporations with access to capital markets took advantage of favorable financial market conditions to issue debt at a robust pace in the first half of the year, and issuance of corporate bonds and syndicated leveraged loans surged. The portfolios of commercial and industrial loans on banks' books expanded as standards and terms for such loans eased further and demand increased. In contrast, despite some improvement over the first half of the year, credit conditions for small businesses appeared to remain tight and demand for credit by such firms was subdued. Financing conditions for commercial real estate assets eased somewhat, but the fundamentals in commercial real estate markets stayed extremely weak.
Household debt continued to contract in the first half of 2011, driven primarily by the ongoing decline in mortgage debt. Even though mortgage rates remained near historically low levels, demand for new mortgage loans was weak, reflecting still-depressed conditions in housing markets and the uncertain outlook for the economic recovery and labor markets. Delinquency rates on most categories of mortgages edged lower but stayed near recent highs. The number of homes entering the foreclosure process declined in the first quarter of 2011, but the number of properties at some point in the foreclosure process remained elevated. Mortgage servicers continued to grapple with deficiencies in their foreclosure procedures; resolution of these issues could eventually be associated with an increase in the number of foreclosure starts as servicers work through the backlog of severely delinquent loans more quickly. Revolving consumer credit--mostly credit card borrowing--also continued to contract, on net, although at a slower pace than in 2010. In contrast, nonrevolving consumer credit, consisting predominantly of auto and student loans, rose appreciably in 2011, as rates on most types of these loans remained near the bottom of their historical ranges and as banks eased standards and terms for such loans. Issuance of consumer asset-backed securities, particularly securities backed by auto loans, was strong.
Conditions in short-term funding markets changed little over the first several months of 2011, although signs of stress for some European financial institutions started to emerge as market participants became more concerned about potential exposures to the debts of peripheral European countries. To continue to support liquidity conditions in global money markets and to help minimize the risk that strains abroad could spread to the United States, the FOMC in June approved an extension of the temporary U.S. dollar liquidity swap arrangements with a number of foreign central banks until August 1, 2012.
Responses to the Federal Reserve's Senior Credit Officer Opinion Survey on Dealer Financing Terms (SCOOS) indicated that dealers continued to gradually ease price and nonprice terms applicable to major classes of counterparties over the six months ending in May, and that demand for funding for a variety of security types increased over the same period. Investor appetite for risky assets likely supported issuance of some debt instruments (including speculative-grade corporate bonds and syndicated leveraged loans) and contributed to a narrowing of risk spreads evident in the first several months of the year. In addition, information from a variety of sources, including special questions in the SCOOS, suggested that the use of dealer-intermediated leverage increased modestly among both levered investors and traditionally unlevered investors, although the overall use of leverage appeared to be roughly midway between its pre-crisis peak and post-crisis trough. In recent weeks, however, anecdotal information has suggested that investors have pulled back somewhat from risk-taking and that their use of leverage has declined.
With the unemployment rate still elevated and inflation expected to subside to levels at or below those consistent, over the longer run, with the FOMC's dual mandate of maximum employment and price stability, the Committee maintained a target range for the federal funds rate of 0 to 1/4 percent throughout the first half of 2011. The Committee reiterated that economic conditions were likely to warrant exceptionally low levels for the federal funds rate for an extended period. At the end of June, the Federal Reserve completed its program of purchasing $600 billion of longer-term Treasury securities that was announced in November. In addition, the Committee maintained its existing policy of reinvesting principal payments from its agency debt and agency mortgage-backed securities (MBS) holdings in longer-term Treasury securities. The Federal Reserve continued to develop and test tools to eventually drain or immobilize large volumes of banking system reserves in order to ensure that it will be able to smoothly and effectively exit from the current accommodative stance of policy at the appropriate time. The Committee will continue to monitor the economic outlook and financial developments, and it will act as needed to best foster maximum employment and price stability.
The size and composition of the Federal Reserve's balance sheet continued to evolve over the first half of the year. As a result of the FOMC's policies of reinvesting principal payments from its securities holdings and purchasing additional longer-term Treasury securities, holdings of Treasury securities rose more than $600 billion and holdings of agency debt and agency MBS declined about $115 billion. Emergency credit provided during the crisis continued to decline: The closing of a recapitalization plan for American International Group, Inc. (AIG), terminated the Federal Reserve's direct assistance to AIG; the Federal Reserve Bank of New York sold some of the securities held in the portfolio of Maiden Lane II LLC, a special purpose vehicle that was established to acquire residential mortgage-backed securities from AIG; and loans outstanding under the Term Asset-Backed Securities Loan Facility continued to decline as improved conditions in securitization markets allowed borrowers to refinance and prepay loans made under the facility. On the liability side of the Federal Reserve's balance sheet, reserve balances held by depository institutions rose to $1.7 trillion, largely as a result of the Federal Reserve's longer-term security purchase program. Federal Reserve notes in circulation also rose. The Treasury Department's Supplementary Financing Account balance at the Federal Reserve declined from $200 billion early in the year to $5 billion as part of the Treasury's efforts to maximize flexibility in its debt management as the statutory debt limit approached.
The economic projections prepared in conjunction with the June FOMC meeting are presented in Part 4 of this report.1 In broad terms, FOMC participants (the members of the Board of Governors and the presidents of the 12 Federal Reserve Banks) marked down their forecasts for economic growth in 2011 relative to their forecasts in January and April, largely as a result of unexpected weakness in the first half of the year. Nonetheless, participants anticipated a modest acceleration in economic output in both 2012 and 2013 based on the effects of continued monetary policy accommodation, some further easing of credit conditions, a waning in the drag from elevated commodity prices, and some pickup in spending from pent-up demand. Participants expected the unemployment rate to trend down over the near term, though at a slower pace than they anticipated in January and April. They continued to anticipate that the unemployment rate at the end of 2013 would remain well above their estimates of the longer-run rate that they see as consistent with the Committee's dual mandate. Participants' forecasts indicated a pickup in inflation for 2011 relative to 2010 and their expectations earlier this year. However, most participants expected that the influence on inflation of higher commodity prices and supply disruptions from Japan would be temporary, and that inflation pressures would remain subdued against a backdrop of stable commodity prices, well-anchored inflation expectations, and large margins of slack in labor markets. As a result, they anticipated that overall inflation would step down in 2012 and remain at that lower level in 2013, moving back in line with core inflation at levels at or slightly below participants' estimates of the longer-run, mandate-consistent rate of inflation.
Participants generally reported that the levels of uncertainty attached to their projections for economic growth and inflation had risen since April and were above historical norms. Most participants judged that the balance of risks to economic growth was weighted to the downside, whereas in April, a majority had seen the risks to growth as balanced. Most participants saw the risks surrounding their inflation expectations as broadly balanced, while in April, a majority had judged those risks as skewed to the upside. Participants also reported their assessments of the rates to which macroeconomic variables would be expected to converge over the longer run under appropriate monetary policy and in the absence of further shocks to the economy. The central tendencies of these longer-run projections, which have not changed since April, were 2.5 to 2.8 percent for real GDP growth, 5.2 to 5.6 percent for the unemployment rate, and 1.7 to 2.0 percent for the inflation rate. Because inflation in the long run is largely determined by monetary policy, the longer-run projections for inflation can be viewed as the levels of inflation that FOMC participants consider to be most consistent with the Committee's mandate to foster maximum employment and price stability.